What is a Profit Sharing Plan?
The Tax Reform Act of 1986 actually made the term
"Profit Sharing Plan" a misnomer, as company contributions
no longer depend on the profitability of the company. Under a profit
sharing plan, the company decides each year what percentage of compensation
should be contributed to the plan. This percentage can be anywhere
from zero to 25% of total participants compensation. The contribution
is tax deductible by the company. The biggest advantage of a profit
sharing plan is its flexibility. The contribution percentage is
not a fixed obligation but rather is determined on an annual basis.
For example, a company could contribute 15% of compensation for
each participant in year one, 3% in year two, no contribution in
year three and 15% in year four.
Types of Profit Sharing Plan Allocation
Salary Ratio Allocation Method
Designed to allocate employer contributions to
all participants on a straight percentage of compensation basis.
Integrated with Social Security Allocation
Designed to give additional allocations to those
employees whose compensation is above the Social Security Wage Base
($87,400 for 2004).
Age-Weighed Allocation Method*
Designed for employers to allocate contributions
based on the age and compensation of eligible employees. Age-weighted
plans greatly benefit employees who are older and closer to retirement.
This could be owners, officers or employees who have been employed
for several years.
New Comparability or Cross-tested Allocation
Designed to allow the employer to divide the employees
into specific groups and allocate the contribution differently to
each group. The employer can give a larger share of the company's
contribution to those employees whom the employer wishes to benefit.
*Employer Contributions must satisfy the
IRC 401(a)(4) nondiscrimination rules.